What Will the Markets Do This Year?

We asked Advisor Partners, LLC, to give us their market outlook for 2014. Advisor Partners handles portfolio management for many of our clients. Here’s what CEO Daniel Kern told us:

Advisor Partners enters 2014 with a favorable outlook for equities, continuing the generally positive view we have had for the equity markets over the past two years. I would characterize us as “reluctant bulls,” similar to many advisors who have large allocations to equities but worry about a market correction. Our overall equity outlook has not changed dramatically as we enter 2014, but our outlook about the relative attractiveness of different equity asset classes has changed over recent weeks.

We are optimistic about the prospects for large company stocks in the US. Our outlook is supported by the improving labor market, rising CEO confidence, and reduced political uncertainty and fiscal drag. While we are aware that stock market valuations are elevated, they still haven’t reached levels that would force a change to our investment positioning (see Chart 1). We are more cautious in our outlook for US small company stocks not only because they have enjoyed a long bull market compared to large company stocks, but also because they are selling at higher multiples on a price/earnings basis.

Looking outside the US, we are more enthusiastic about European stocks than we were last year at this time. We added money to European stocks during the second half of 2013 because we observed the incremental improvements in economic momentum and we think that the European Central Bank has made meaningful progress in reducing the risk of a policy-induced calamity (see Chart 2). We expect some selling pressure in Europe early in the year as portfolio managers take profits and reduce risk in their portfolios. Many investors wonder whether the beginnings of economic growth are sustainable, and they worry about deflationary pressures and the continuing credit crunch. We continue to see good investment opportunities in Europe, but we are mindful of the risks.

Chart 2: Europe Had Economic Momentum in 2013

Source: BCA Research, Markit,*Institute for Supply Management

Japan continues to be an interesting market for investors, as Prime Minister Abe tries to balance the need to stimulate and reform the Japanese economy while dealing with a fiscal and demographic picture that is among the most challenging in the world. We don’t envy his task and will be watching developments closely in the coming months.

We have turned more negative on the near-term outlook for emerging markets. We are concerned about decelerating credit growth within emerging markets, deteriorating profitability and productivity in much of the emerging world, and the challenging adjustment period China faces as it implements a series of structural reforms, (Chart 3). China is taking what we think are meaningful and positive steps to deregulate the banking sector, reduce state involvement in the economy, and balance the very different considerations for residents of urban areas relative to those in the countryside. However, we think that many underestimate the magnitude of these structural reforms and the amount of time it will take for the reforms to pay off.

Beyond China, we expect a challenging period for emerging markets from an economic and political perspective. We do, however, want to stress that our longer-term (beyond one year) perspective is that emerging markets will offer compelling opportunities for investors. In the near-term, though, we are emphasizing a selective approach to emerging markets, recognizing the need to distinguish between countries that have more or less favorable fundamentals.

Chart 3: Emerging Markets Are Deteriorating

Source: BCA Research • *Shown as a 6-month moving average • **Calculated as the average of return-on-assets and return-on-capital ratios

Commodities are another asset class that will require a selective approach in the coming year. Even as China’s economic and social reforms are rolled out, that country’s industrialization will continue to support demand for industrial metals. The economic growth that we expect mainly in the developed world will be a boost for energy prices as well. Some agricultural products whose prices were hurt by excess supply in 2013 may rebound slightly in 2014, including sugar and corn. Precious metals, on the other hand, are not poised to do well in the coming year. With little fear of inflation and a strong demand for yield, there isn’t likely to be an increase in demand for assets that offer inflation protection but not yield.

We continue to prefer equities to fixed income, even though Treasury securities have become a somewhat better value in recent weeks. We expect intermediate- and long-term Treasury yields to trend up over the next 12 to 18 months, although the Federal Reserve will continue to hold short-term rates close to zero. Within fixed income, we prefer taking credit risk to interest-rate risk given our outlook for the economy and for interest rates. Consequently, we are allocating more to high-yield and investment-grade corporate bonds and less to Treasury securities than we would if interest rates were higher. Although high-yield bonds are considerably less attractive than they were at the start of 2013, economic fundamentals, strong corporate balance sheets, and declining default rates provide support to our continued ownership (Chart 4).

We have had many discussions internally and with our clients about the risk of a major pullback in the equity markets. Given the dramatic rise in the market during 2013, we think there is a greater risk of a correction of 5% to 10%. Valuations are somewhat elevated and many investors are nervous bulls, looking for an excuse to take profits or some other reason to sell. However, we don’t see the typical warning signs for a more substantial or longer-lasting correction. Inflation is under control, and there are no signs that fiscal or monetary tightening is an imminent threat. Imbalances such as buildups of debt or inventory that can trigger recessions aren’t an evident threat either. We are aware that economic or geopolitical shocks represent a threat to our bullish scenario, and we will continue to watch for signs of emerging issues that would cause us to revise our outlook.

Please feel free to contact Accretive Wealth Management with any questions or concerns. Just call (925) 365-1533 or send an e-mail to lifeplan@accretivewealth.com